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 BP Plc Pre-results Update – 22 October 2014

 

Company Overview:

Founded in 1908, BP Plc (British Petroleum) is one of the world’s largest oil and gas companies. It operates under two business units: Exploration and Production followed by Refining and Marketing.

Worldwide, BP pumps 3.2 million barrels of oil equivalent per day, employs 83,900 people and has 17.9 billion barrels of oil equivalent in proven reserves. It also owns and operates 14 refineries as well as 17,800 retail sites (petrol stations) across the globe.

 

Index FTSE 100 Ticker BP.L Latest Close 432.00
52 Week High 527.13 52 Week Low 405.00 P/E 6.38
Dividend Yield % 5.4 Dividend Cover 3.35 Dividend (Pence) 23.40
CEO: Bob Dudley CFO: Brian Gilvary Price Target 385.00


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BP shares drop to 18 month low, outlook darkens

When covering BP in early August we assigned a negative outlook to the shares as the geopolitical environment deteriorated at the height of the Ukraine crisis, prompting us to consider the implications for the group’s substantial shareholding in state owned oil giant Rosneft if the sanctions war between the west and Russia was to escalate.

Since this time, a fragile ceasefire agreement has seen the conflict in Ukraine gradually fade from the headlines, although geopolitical risk has continued to lurk in the background and has therefore remained a factor in BP’s share price weakness. In addition to the issues surrounding Ukraine and Russia, there have also been other drivers behind the previous sell off.

With the shale gas revolution in North America, US oil output has reached a multi decade high during the summer months of 2014. This has led to reduced reliance upon international markets at a time when demand growth from China is flagging and some of the euro-zone economies appear to be heading back toward the rocks.

As a result, Brent and WTI crude benchmarks have fallen to multi year lows during the third quarter.

This has also been a further significant driver behind the decline in BP’s share price, as well as those across the wider sector, which has sold off sharply over the last six weeks.

BP Plc Share Price // Daily Intervals

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Brent/WTi Crude Overlay // Weekly Intervals

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Legal battle takes a turn for the worse as BP found grossly negligent

While cyclical and macroeconomic factors have posed significant challenges to management across the commodities space, BP has also faced additional barriers to progress as a result of ongoing legal action over the Deepwater Horizon accident in 2010.

Earlier this year, the group was found to have been grossly negligent and a party to “wilful misconduct” during the months leading up to the accident. Despite that the group intends to appeal the verdict vigorously, the current position of the US courts holds that BP is now liable for enhanced civil penalties under the Clean Water Act (CWA).

Although it will be some time before the end liability is determined, we do know that the CWA permits fines that could be anywhere between $1,100 and $4,400 per barrel spilled.

While this may not seem like much at a first glance, the rub is that the total number of barrels which BP will be fined for is also still to be determined; by a US District Judge.

On this subject, we note that the EPA (Environmental Protection Agency) has produced estimates that place the figure as high as 4.9 million barrels, with an implied financial liability that ranges from $5 billion to $21 billion.

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Shareholders to sue BP in US courts

If the board at BP though that the gross negligence verdict would place them somewhat closer toward the point where Deepwater Horizon can be consigned to the history book, the beginning of October will have forced them to think again.

This was as a group of BP shareholders, many of them institutional investors, won a landmark victory earlier in the month when US district Judge Keith P Ellison ruled that the negligence claims of shareholders relating to the 2010 incident can be heard in US courts.

Previously BP had hoped that shareholders seeking damages from the group would be forced to do so through the UK court system where subsequent financial penalties will have, in all probability, been much lower than in any US court.

The verdict could potentially pave the way for a class action lawsuit, brought by shareholders, that may lead to yet more record fines for, rather ironically, BP shareholders.

“BP believes that all of the plaintiffs’ securities claims relating to the Deepwater Horizon accident are meritless, and it will continue to vigorously dispute them.” — Official BP reaction

While we note that the group maintains a strong balance sheet cash position ($27.5 billion @ 30 June), a class action lawsuit combined with the CWA fines would be likely to see this cash pile dwindle fast.

For this reason the potential class action by shareholders is a cause for concern as it could, if successful, see the group undercapitalised at a time when margins are already under substantial pressure.

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Current rhetoric and research suggests Saudi Arabia will not cut oil production to support prices; further downside is a possibility

The summer decline in oil prices presents a catch 22 for UK focused investors. This is most notably because weaker crude is damaging for the outlook among many investor favourites in the oil & gas sector, companies such as BP and Royal Dutch Shell. However, it is not all bad news as weaker oil prices will suppress inflation and support growth.

On this note, many investors had previously assumed that Saudi Arabia would eventually move to tighten supply in order to support prices and thus, were unperturbed by the deteriorating outlook for the sector. However, four weeks ahead of the next OPEC meeting, this assumption is beginning to look increasingly flawed.

This is as early indications of Saudi Arabia’s position on the recent oil price decline suggest that the “swing producer” may be willing to tolerate low price for as long as is necessary for it to defend its market share. Reuters reported during early October that Saudi oil ministers could be willing to accept prices below $90 per barrel for some time to come.

While it is almost certain that Saudi Arabia has a critical role to play in determining the direction of oil prices during the months ahead; its motivations for remaining tight lipped, following a breach of the $100 and then $95 price levels, remains unclear.

Some observers have suggested that it may be part of a wider move to force other OPEC producers to accept a share of the production cuts, while others believe the group is keen to preserve market share in the face of reducing demand from North America.

Nevertheless, and regardless of its motivation, the hopes of oil companies that Saudi Arabia will intervene to support prices may prove to be just that; hopes.

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Lack of Ukrainian winter gas deal with Russia is a risk to all

While developments in the Ukraine crisis dominated both headlines and financial newswires throughout much of H1 2014, the prevailing sense of indifference that has enveloped investors since the implementation of a ceasefire in September belies hidden risks.

In detail, we are concerned that political squabbling and the ongoing sanctions war between the west and Russia poses risks to both Ukrainian and European gas supplies this winter.

With Petro Poroshenko and Vladimir Putin failing on multiple occasions to agree a winter gas deal, the possibility that Ukraine will have insufficient supplies to get through the harsh eastern European winter has increased.

Further from here, previous attempts by fellow eastern European states to “reverse flows” and effectively buy gas on behalf of Ukraine failed when Russia reduced supplies to Poland in retaliation against the nation’s efforts to support its neighbour.

On this note, in mid September Russia’s energy minister publicly warned all European states against re-exporting Russian gas to Ukraine, implying a willingness to impose restrictions upon nations outside of its immediate sphere of influence if it becomes necessary.

Should gas supplies to Ukraine or main-street Europe be compromised during the winter then this would almost certainly lead to a further deterioration in geopolitical relations and in the case of Ukraine, further civil unrest.

Such a scenario could see the Ukraine crisis, rejoining ISIS, Ebola and European economic stability in the the headlines as well as at the forefront of investors concerns.

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What all of this means for BP

With geopolitical and sentiment risks aside, margins are likely to come under pressure with any further declines in oil prices. This forms the predominant visible threat to BP over the coming weeks and months as it could compromise the group’s ability to meet rising litigation costs and its pledge to return more cash to shareholders.

Further from here, we are skeptical of the group’s ability and willingness to increase cash returns to shareholders over the near term. We also believe that the turn for the worst in its US legal battle will lead BP to announce higher than expected provisions for such costs when the group delivers Q3 results in late October.

As a result, we anticipate a disappointing update from BP management at the end of this month, one that is likely to be followed by cautious at best, but most likely negative guidance for the full year outlook.

With this in mind, we see little scope for a meaningful recovery in the share price from current lows. On such a note, we see any gains between now and the end of October as likely to be capped at 460.00 pence.

This is while we also view any form of negative update from management on 28 October, if taken with continued pressure upon oil prices, as likely to provide a green light for further selling of BP shares.

This could see the way open for an additional leg down toward the 61.8% retracement level at 385.00 pence, which corresponds to the long term upward trend established by the shares between July 2010 & July 2014.

All in all, we expect that the shares will find it difficult to make headway for some time to come as the effects of positive news flow relating to divestments and potential progress in the US courts from H2 in 2013 has now dissipated.

In place of the previous brightening outlook is now an abundance of risks to assets, earnings and shareholder returns. While we accept that there is likely to be a limit to the extent which the shares can fall further, we also struggle to see any potential drivers for a sustainable correction to the upside.

Accordingly, we shall cast our final judgement after having had the opportunity to review Q3 results & the management update at the end of this month.

 

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